Last week, the GDB sent a letter to Puerto Rican lawmakers explaining that the Government would run out of liquidity in 3 months and that this would result in a Government shutdown. 

The letter has resulted in all sorts of political responses and posturing but the truth is that lenders will not lend Puerto Rico significant amounts of money unless a credible and balanced budget is passed. This new budget will need to include a new tax regime which significantly reduces tax evasion and results in sustainable and predictable revenues. Along with predictable and sustainable revenues, cuts also need to be made to Government expenses. 

Once congress passes a credible budget, PRIFA can come to market and lenders will likely lend the 2.9 billion needed to pay down GDB loans to PRHTA. This will give the GDB the liquidity needed to help Puerto Rico operate.  Sometimes the truth hurts, but often a little hurt is needed to get legislators to move forward. 

SP downgraded PR GOs to CCC+ citing the risk that legislators may not agree on tax reform and a balanced budget which would prevent the PRIFA deal from getting done. Market prices have not weakened on this news and are holding steady indicating that this risk may be priced into the market.

It is no secret that there is a large "underground economy" in Puerto Rico and that the Puerto Rican Treasury collects very little tax revenue from this economy. This, of course, unfairly increases the tax burden on those participating in the "above ground economy". The Administration's answer to this growing problem is a Value Added Tax (VAT)

As we have described in earlier posts, the Value Added Tax is collected at every stage of sale. The Administration is proposing a 16% VAT so it would work like this. The Baker buys a bushel of wheat from the Farmer for 10 dollars plus 1.60 VAT tax. The Farmer pays the 1.60 to the Treasury. The Baker makes 10 loaves of bread from the wheat and sells them to the Grocer for 20 dollars plus 3.20 VAT tax. The Baker reimburses himself for the 1.60 he already paid to the Farmer and pays the remaining 1.60 to the Treasury. The Grocer sells the 10 loaves of bread to the Consumer for 40 dollars plus 6.40 VAT. The Grocer reimburses himself for the 3.20 he paid to the Baker and pays the remaining 3.20 to the Treasury.  At the end of the day, the Treasury collects 1.60 from the Farmer, 1.60 from the Baker, and 3.20 from the Grocer (a total of 6.40 on the final 40 dollar sale). The unique aspect of this system is that the Baker is incentivized to collect the taxes from the Grocer to reimburse himself for the taxes he paid to the Farmer and the Grocer is incentivized to collect taxes form the Consumer to reimburse himself for the taxes he paid to the Baker and so forth. 

Naysayers talk about the regressive characteristics of the tax. The Administration has proposed to eliminate Income taxes for individuals making 40,000 or less or couples making 80,000 (well over half of the labor force). In addition, those earning less than 35,000 will receive a rebate on paid taxes on purchases and prescription drugs, food, and public education are exempt form the VAT.

In total, the Administration projects to collect approximately 2.5 blln more in tax revenues than in 2014. If the tax reform is passed and implemented successfully, the additional revenues will go a long way to help put the budget in a surplus situation. It would be naive to assume that there won't be hiccups in the implementation.

From an investment standpoint, the credit of the Sales Tax Bonds could improve dramatically. Currently these bonds are supported by sales tax collections (about 1.4 blln per year), the new VAT is expected to collect 6.5 blln (and remain a senior claim for the bond holders).

A local judge voided the "Restructuring Law" passed in June 2014. The "Restructuring Law" outlined a "process" for restructuring the debt of Puerto Rican public/private Agencies. 

Since States, Territories, and Municipalities of Territories are not permitted to file for Chapter 9 bankruptcy protection, Puerto Rican Agencies needed a Law to help them resolve future and inevitable short falls. Without a Law, creditors would need to sue in local courts; a long and unproductive process indeed.

The market seems to believe that this news is a positive for Agency creditors and a negative for GO creditors; price action supports this view. 

We have a slightly different take; here are our views on the various credits:

Agency Debt - No Change - Although creditors seemingly have another "option" (to sue in local courts), we do not believe they are any better off. In fact, suing in local courts could result in a worse result than chapter 2.

COFINA Debt - Better - The local judge voided the Restructuring Law because it violated the Takings Clause and the Contracts Clause of the US Constitution. This should help put to rest any fears that the Administration will "claw back" taxes that are contracted to go to COFINA bond holders  and should be a positive for these credits.

GO Debt - No change - We still believe that the Administration will do everything it can to protect the GO debt holders and uphold the Constitutional priority of the debt service.

General Fund revenues continued to decline in December with Foreign Corporate and Motor Vehicle taxes down the most. General Fund net revenues are down 5% or 200 mlln for the year. 

The Sales and Use taxes, however, were up 12.5% in December and are up 13% for the year. These tax revenues, which support the COFINA bonds, are up 80 mlln compared to last year.